Investing – Options Trading Basics

Options can be a good way of investing your money, even if you are not wealthy to begin with. If you already have some basic knowledge of trading in stocks and bonds, you are well aware of the wide range of strategies that can be used. Everything from the basic buy and hold to those which use complicated technical methods of analysis are utilized. Likewise, there is a similar range of strategies, which can be used for options trading.

Essentially, options are contracts that confer the right to buy or sell a specific stock, bond or similar type of underlying instrument at a particular pre-determined price, within a specific time limit. Options, which give an investor the right to buy, are known as call options, while those giving the right to sell are put options.

The investor can act at any time, up to and including the expiry date, if they are holding what is known as an “American” option, while those known as “European” options can only be acted upon on the actual expiry date. There is no real geographical difference in these options types any more, although they did historically belong to the US and Europe. The American options are often used for stocks or bonds, while the European versions are commonly used for indexes.

The expiry date generally falls on the Saturday following the third Friday of the month in which the option contract expires. Since most investors will be unable to contact a broker on a Saturday, as well as US exchanges being closed, the expiry date will effectively be the third Friday of the month.

With an investment in an American style option, for example an option in stocks, there are two possible outcomes. The investor can either wait for the expiration date, or they can act before the option is mature. (Obviously, for a European style option there is no such decision to be made). Many investors do wait until the expiry date before they do anything, regardless of the type of option they hold.

A typical option will be for one hundred share lots. If the investor is buying a call (right to buy) option for two dollars in a stock that has a strike price of twenty-five dollars, then this will cost them (2 + 25) dollars x 100, that is $2700, plus commissions. As long as the market price is more than twenty-seven dollars this investor is doing well.

If the investor believes that the price has reached its peak before the expiry date, is unlikely to recover again, and it is above twenty-seven dollars, they then can sell early and make a good profit.

It can also be sensible to sell before the expiry date if the price is below the strike price and is probably going to keep going down, or it is already very near to the expiry date and likely won’t have a chance to recover. Getting out early can reduce the overall loss. It is possible to use this loss to offset capital gains tax too.

There is a third choice as well, rather than acting before the expiry date or waiting for the option to reach maturity. The option is a chance to buy or sell, but it does not oblige the investor to do so. The contract can be left to expire, with no action taken on or before the date of expiry. It can on occasion result in a smaller loss to just let the option expire as opposed to using it. There is no obligation to take your buying or selling rights, unlike when you put your money into futures. Whether or not it is a good idea to give up your right will depend on a number of factors such as the strike price, the market price and the premium.

As with any investment, options carry risks. The rise and fall of stock prices and other underlying instruments will occur unpredictably over unpredictable periods of time. The price of an option can vary over time according to these fluctuations and the length of time that is left before they expire. The expiry date is an important feature of options trading, as its distance in time will influence the investor’s decisions.

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